Junk Bond ETFs Hit By Cheap Oil

I added a wrinkle to the above chart: the PowerShares Senior Loan ETF (BKLN | B). BKLN isn’t a junk bond fund, but many investors have flocked to it for the same reason they buy junk bonds—yield.

BKLN holds floating-rate notes that are generally below investment grade. They have similar default characteristics to junk bonds, but can actually see spikes in defaults from rising rates, so it’s worth being extra weary. Still, the comparison is apt: HYG is currently advertising a yield to maturity of 5.89 percent.

Energy-heavy JNK is showing 6.69 percent, and BKLN is in the ballpark at 4.82 percent. Yield to maturity is the rate of return anticipated on a bond if held until the end of its lifetime.

Is One Better Than The Others?

That lower yield in BKLN is partially explained by its shorter-term nature (the average reset for the loans it holds is generally a month, whereas generally the bond funds hold paper that matures in 5-6 years). But some of it can also be explained by the sector breakdown—BKLN has just 5 percent of its portfolio exposed to the energy markets.

Does this make BKLN a buy and the others a sell? Not necessarily. The point of investing in junk bonds is, after all, to take a little speculative risk in return for the higher yields. Oil exploration and production company debt is currently yielding in the range of 10 percent—that’s a pretty fat coupon check to get every quarter.

The question is, how much risk are you really taking? There’s little question there will be some defaults next year, but how many is just a guess. Some pundits, like Martin Fridson of Lehmann Livian Fridson, is predicting a huge increase in overall junk defaults—but not for several years. Others are predicting a more modest bump from the current levels of around 1.9 percent a year to 2.5 percent.

If that’s the case, an indexed approach that spreads that risk out, but still captures those higher yields, may be just what the doctor ordered. That’s certainly what the hedge fund community is counting on—it’s been the big buyers of this year’s junk bond offerings. ETF investors seem pretty happy to stay the course as well—HYG and JNK have pulled in almost $3 billion in new assets so far in the fourth quarter.

At the time this article was written, the author held no positions in the securities mentioned. You can reach Dave Nadig at [email protected], or on Twitter @DaveNadig.